By Bellwether

Nov 21, 2017 08:45 AM GMT+0530 | 1 Comment(s)

MERCANTILIST MYTH: That a widening current account deficit causes balance of payments crisis and currency collapses rather than central bank money printing is an enduring neo-Mercantilist myth. It is a throwback to the obsession with the trade deficits, a key plank of classical Mercantilism.

ECONOMYNEXT - Sri Lanka's new trade policy published in the ministry of development strategies and international trade says a lot of home truths protectionism, but it also reinforces a dangerous Mercantilist myths that can hurt the poor and increase public discontent.

Such beliefs can undermine the entire reform strategy like it did in the 1980s.

An enduring myth in Sri Lanka has been that balance of payments crises are caused by trade deficits. This is one of the original classical Mercantilist myth dating back to the 17th century.

It is the very same myth that drives protectionism and allows politically connected producers and farming lobbies to exploit poor consumers with import taxes.

Current Account Fallacy

The New Trade Policy goes someway to debunk the classical Mercantilist myth but replaces it with a neo-Mercantilist one.

"The imposition of import controls does not reduce excess demand, which can be considered as the main cause of a current account deficit," it says.

"In addition, import restrictions can contribute to widening the trade deficit by discouraging exports (generally speaking import restrictions are a tax on exports)."

If excess demand is a reference to money printing by the central bank, it is true that balance of payments crisis (an outflow of foreign exchange greater than inflows) occurs when money is printed by the Central Bank.

However it is only partly true that current account deficits are caused by excess demand, though certainly an increase can happen when printed money turns into imports either through straight state spending or through bank credit.

Any country with a capital surplus can run a current account deficit when the proceeds of capital flows (foreign direct investment or foreign loans) are spent within an economy, generating imports.

When FDI comes it causes an import of material for factories, or buildings or machinery. If the government borrows abroad for roads in causes an import of cement or steel.

But that does not have an effect on the exchange rate, since any import is financed by a capital inflow. Countries like Sri Lanka also gets a lot of remittances officially and also unofficial channels, which when spent will contribute to a trade deficit.

On the other hand, a country like Germany, which has a surplus budget, or whose companies invest heavily in factories in East Asia or Eastern Europe can have a current account surplus.

Sri Lanka borrows heavily abroad generating a current account deficit, and it also has a persistent trade deficit because there is remittance inflow which creates income above Merchandise exports.

"Although this is not a large deficit by international standards, concerns about the current account deficit are justified because it has been a recurrent driver of macroeconomic imbalances and subsequent growth slowdowns in Sri Lanka," the trade policy also claims.

"The current account deficit remains persistent despite the large windfall from lower oil prices and Sri Lanka’s foreign currency reserves are barely adequate, standing currently at 3.8 months of imports."

There is no windfall from lower oil prices. When oil prices are cut, non-oil imports will go up as more money is left in the hands of people, just as oil price hikes, reduce non-oil imports.

This column warned that non-oil imports would go up as early as late 2014, when then President Mahinda Rajapaksa announced oil price cuts as part of election moves.

An outflow of money through capital flight may also reduce the money available for imports, and a currency may fall even if the current account deficit narrows.

For example Sri Lanka's current account deficit in 2014, was 1.99 billion US dollars, in 2015 it was 2.09 billion US dollars, and later revised down to 1.89 billion US dollars and in 2016 it was 1.9 billion US dollars also.

All this shows not only that losing sleep over current account deficits is a waste of time, but also the powerful grip of Mercantilism in most countries that have pegged exchange rates.

"Low Nominal Exchange Rate' Myth

Then the trade policy goes on to state an outright lie.

"The Central Bank of Sri Lanka attempted in the past to keep the nominal exchange rate low (i.e strong)," the policy says.

"It led to large balance of payments deficits, loss of reserves, and borrowing at commercial interest rates that increased external debt."

For one thing the rupee fell from around 105 to 120 to the US dollar during the 2008/9 BOP crisis bu was allowed to strengthen when credit eased, and it also fell in 2012, but it was kept at the fallen level of 130 to the US dollar.

Admittedly however the depreciation was less than in the 1980s, strike driven turmoil years.

The central bank also did not lose reserves by trying to 'keep the nominal exchange rate low' (this is probably meant to say that the exchange rate is either fixed or strong), as it is claimed.

The central bank lost reserves by selling reserves, and printing money after the dollar sales to stop the interest rates from going up (sterilized forex sales). Put another way the CB kept interest rate low by printing money creating excess demand.

It recovered the reserves by sterilizing the purchases (selling down Treasury bills it bought to create the BOP crisis in the first place), as it is doing now.

The other claim made is that an exchange is 'overvalued or undervalued'.

In fact the International Monetary Fund concluded that when this administration came to power, said the rupee was not noticeably 'overvalued' by several separate measures.

Claims of exchange rate 'undervaluation' especially in East Asia is a myth devised by US Mercantilists.

This column has previously shown that is a well-developed false doctrine, through which the Japanese and Chinese nominal exchange rates were forced to be appreciated, but which failed to narrow the deficits with the US.

US mercantilists are also using circular arguments to make their case.

One of the metric through which 'undervaluation' in East Asia also includes a current account surplus. If a country in East Asia runs a current account surplus, it is assumed that the currency is undervalued.

In reality however, an exchange rate moves based on the monetary policy that is adopted. There is no market determined exchange rate. There is an exchange rate that is determined by a particular monetary regime that is adopted.

The Deadliest Fallacy of them all

The deadliest fallacy in the New Trade Policy goes as follows.

"Also, when real exchange rates appreciates, it encourages more capital intensive production and discourages greater use of labour abundant resources," it says.

What labour abundant resources prey? And isn’t capital intensive production just what this country needs?

Sri Lanka is short of labour. The population is ageing. We are no Vietnam with a massive young population. The population in Sri Lanka is visibly old now.

The old argument for currency depreciation to boost exports was based on two arguments. The slave labour argument and the poverty argument.

The poverty argument simply says that a weaker exchange rate will reduce the incomes of domestic citizens and create a greater exportable surplus. This does not hold now because industrial goods exports which the elites want requires technological and marketing know how to produce and sell and Sri Lankan firms make protected expensive products.

The slave labour argument says that when the currency falls, wages will fall, and the producers will get more profits at the expense of labour and there will be more investment flowing into exports, and they may be also be able to cut some prices and win market share.

For one thing this strategy implies a subsidy to exports over all other sectors of the economy.

For another, it assumes that people will stay in one place and move like cattle to the factory floor for low salaries as the hard goods export-happy elites want.

Productivity and Real Wages

The claim that a strong exchange rate 'encourages more capital intensive production' is actually quite true.

Prime Minister Ranil Wickremesinghe has said that he wants to create high paying jobs.

The only way to increase labour productivity is to have more capital investment. If the currency is depreciated, salaries and capital (which can bring higher salaries later) will both be destroyed.

It is an undeniable fact that industrial export growth is linked to foreign direct investment. This is because foreign companies in competitive markets develop the latest designs, technology and efficient production techniques to keep customers happy and costs down.

All this move into a country, when FDI comes in and transforms a sector.

In many countries export firms pay the highest wages. Driven by FDI, they push productivity up and drags salaries of non-trade sectors also up.

This is a key reason for the inflation index even in a like Hong Kong (which is has a currency board with the US dollar) can grow faster than the US. Paradoxically, productivity growth in traded sectors can drive up salaries in non-trade sectors, and pushing price indice up.

For example labour demand and higher salaries in tourism, may drive up salaries in restaurants and retail sectors, causing some prepared foods (like hoppers or kothu rotti, or rice packets) to go up in price, until the way they are prepared changes (such as with mechanization).

To target a Real Effective Exchange Rate (as Sri Lanka is doing) in this context is suicidal.

Higher wages will only come to exports when and (if) new investments and factories are built. Existing firms will not want to raise wages too much. That is why these firms find it difficult to make new hires, while other sectors are paying higher wages.

Domestic sectors which have seen a lot of investment now pay higher wages. Recent gwoth in construction was driven by both private investments and state borrowings. But areas like IT and tourism driven by real private investment.

From construction to even road cleaning, capita investment is boosting labour productivity. Abans is using mechanized sweepers to clean roads.

An analysts by Harvard economist Ricardo Hausmann, who has been analysing Sri Lanka, domestic industries like construction, pays higher wages than export industries in Sri Lanka.

This is in sharp contrast to Panama where export industries and services pay higher wages, than non-traded sectors. Hausman's choice of Panama is interesting. Panama is a country where the option to generate slave labour style exports by currency depreciation is not available to policy makers, because there is no central bank to bust the 'Balboa' which is mostly a coin.

Panama is a 'dollarized' country using dollars. Like a currency board, no depreciation is possible to combat perceived Mercantilist overvaluation in that country.

While many South American nations built Sri Lanka-style central banks, and deteriorated into revolutionary hell-holes Panama stood tall. When a country is dollarized or there is a currency board, a hard budget constraint is created to make deficit spending difficult.

Panama is also financial centre, like other countries that do not have soft pegs. Sri Lanka's aspirations for a financial centre will also be doomed if it continues to have a soft-peg, which crawls incessantly downwards.

In a dollarized country, rulers cannot print money, borrow excessively and impose backdoor 'hair cuts' on public and private debt (bank deposits holders and pensioners) through currency depreciation on guise of boosting exports.

Any haircuts - like in Greece - will be transparent and visible.

If the elite policy makers destroys the currency, and expect exports to be boosted by unsound money amid labour shortages, they are sadly mistaken.

The 'enslaved' labour, denied a living wage, will not sit still as currency depreciators expect.

Monetarily enslaved labour is mobile

In Sri Lanka massive migrations of labour started to happen from the severe currency depreciation years of the 1980s and freedom was given for people to move out.

Even government servants went abroad. Highly qualified people migrated to international agencies and Western countries while labourers and housemaids went to the Middle East, Singapore and Maldives.

Middle level government workers like teachers went to the Maldives or the Middle East.

Maldives which is based on fishing and tourism has a much more stable exchange rate than Sri Lanka.

Even now many skilled workers in Sri Lanka are giving up jobs they already have and are moving to the Middle East, Maldives, Korea, Japan or even Malaysia legally and illegally.

They have aspirations which do not match with the elites' view of herding them to the factory floor to earn wages whose purchasing power has been robbed by the central bank through currency deprecation.

If there was no eco-system of job agencies, friends and neighbours who have already made good going abroad for one or two years to come back with savings, the 'enslaved labour' and weak currency strategy may work.

But that is not the reality. The reality is people know how to go out of the country, job agencies are there, and there are a bunch of countries in the Middle East, Maldives and East Asia that are willing to accept them.

There are even people, like mechanics, working for US defence contractors in the Middle East.

At the moment, the prospects of getting jobs in the Middle East is dim due to low fuel prices. But people still have aspirations.

Each time the currency falls, the number of passports issued goes up steeply.

While association may not be causation, it is self-evident that attractiveness of foreign jobs go up after currency depreciation, while domestic inflation makes lives difficult as real wages are destroyed.

New passport issues grew relatively anaemically from 507,949 to 523,000 in 2011 with the exchange rate stable. Only in the latter part of 2011 did the rupee start to weaken with a cycle of money printing and currency defence.

In 2012, the rupee was floated.

The currency fell to 127 to the US dollar by year end. Passport issues jumped to 570,000 by the end of the year. Middle Eastern passports jumped to 230,000 from 196,000.

By 2015 when this administration came new passport issues to the Middle East fell to 176,000 a year, though the total to all countries rose.

The rupee stared to weaken only in the second half of the year. By end 2016 the rupee had collapsed to 150 rupees. Middle Eastern passport issues rose to 200,311 despite a downturn and all countries rose to a record 422,394.

Total issues passport issues soared to an all-time high of 658,000, from 491,000 a year earlier.

While the reasons for the record passport issues need deeper study, anecdotal evidence suggests that at least a part of those who bought the passports were foreign job seekers.

The pressure on the working class from currency depreciation is unlikely to make for a contented workforce or electorate.